Modelling catastrophic risk in international equity markets: an extreme value approach

Abstract

This letter uses the Block Maxima Extreme Value approach to quantify catastrophic risk in international equity markets. Risk measures are generated from a set threshold of the distribution of returns that avoids the pitfall of using absolute returns for markets exhibiting diverging levels of risk. From an application to leading markets, the letter finds that the Nikkei is more prone to catastrophic risk than the FTSE and Dow Jones Indexes.

Acknowledgements

University College Dublin's Faculty research funding is gratefully acknowledged.

Notes

¹ In contrast, in a qualitative sense, catastrophic risk requires market participants such as investors and bankers agreeing on the occurrence of extreme events. Kindleberger (2001) notes that these extreme events are a result of irrational speculation in the form of manias and panics, accurately describing the large decline in international markets during the 1987 crash.

² Alternative applications of EVT include modelling margin requirements (Dewachter and Gielens, 1999) and stability in foreign exchange markets (Cotter, 2005b).

³ EVT is commonly applied in the financial economics literature, and for a comprehensive discussion of the theoretical framework see Embrechts et al. (1997). Following convention we will focus on the maxima but alternatively one could detail the minima for the lower tail of a distribution. Alternative non-pararmetric approaches have also been applied in modelling tail behavour (see Cotter, 2004).